What Is Adjusted Gross Income (AGI)?
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Understanding Adjusted Gross Income (AGI)
AGI is a variation of the gross income that accounts for specified deductions allowed by the IRS. These adjustments and exemptions are important for calculating taxable income. The IRS also relies on the AGI to determine what deductions and credits a taxpayer may qualify for in a tax year.
It is important to recognize three key income numbers and how they correlate to understand these processes.
- Gross income — The total amount of money earned in a given year. It includes salaries, wages, self-employment income, capital gains, tips, retirement distributions, and other sources of earned income.
- Adjusted gross income — AGI is what is left of the gross income after eligible deductions allowed by the IRS have been subtracted. It is typically the foundation for calculating how much income tax a taxpayer owes for that year.
- Taxable income — This is the maximum income amount on which tax payments are based. Any qualified tax deductions are applied to the AGI to arrive at the taxable income, which is then multiplied by the applicable tax rate.
Note that while both terms refer to gross income minus deductions, AGI is not synonymous with net income.
Net income is the “take-home pay” that an individual or company is left with after all deductions, premiums, fees, and taxes are made on the gross personal or business income.
On the other hand, AGI is gross income minus adjustments made for eligible deductions so the IRS can arrive at a taxable income figure. In other words, the AGI is gross income that has not been taxed yet. In addition, AGI is declared on special IRS forms, namely Schedule 1 and Schedule A of Form 1040.
Types of Deductions
When calculating AGI, there are two categories of deductions under the Internal Revenue Code—above-the-line and below-the-line.
Above-the-line deductions are qualified items that are subtracted from the gross income to arrive at the adjusted gross income. Above-the-line deductions typically hold more value since they can reduce the AGI and, as a result, a person’s tax bill.
On the other hand, below-the-line deductions are itemized adjustments that refer to any other allowable deductions that can reduce the taxable income but do not influence the AGI.
Common Above-the-Line Deduction Items for Calculating the AGI
Some taxpayers can make multiple deductions from their gross income, whereas others might not qualify for any deductions. It all depends on if the taxpayer meets the eligibility requirements of the IRS.
In any case, some common above-the-line deduction items allowed by the IRS include the following.
Educator expenses apply to teachers and other education professionals, allowing them to deduct up to $250 from their gross income for out-of-pocket expenses.
These unreimbursed expenses must be related to education, such as books, school supplies, professional development courses, computer equipment and software, and so on.
Contributions to Health Savings Account (HSA)
HSA payments allow people to pay for unreimbursed medical expenses not covered by insurance. Deposits paid directly into an HSA account are tax-exempt and can be eligible for above-the-line deductions, provided the individual is already enrolled in a high-deductible health plan (HDHP).
Other criteria include not having any other health coverage except worker’s compensation, not being enrolled in Medicare, and not being claimed as a dependent on another person’s tax return.
Contributions to certain charities and foundations may be deductible from one’s gross income when computing their AGI. Typically, the IRS only allows deductions if the donation was to a 501(c)(3) organization or any other qualifying tax-exempt organization.
For individuals, there is a cap on the maximum amount allowed for deduction—$300 if the taxpayer is single or filing separately and $600 if the taxpayer is married or filing jointly.
Contributions Made to Qualifying Individual Retirement Accounts (IRAs)
Contributions to traditional IRAs may be deductible when calculating the AGI. This is known as a pretax contribution, and it allows individuals to postpone tax payments on the amount they contribute as long as the funds remain in the account.
Certain qualified retirement plans for self-employed individuals, including the Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) IRA programs, may also be eligible for above-the-line deductions.
Moving Expenses for Members of the Armed Forces
Per the IRS publication on Military Adjustments to Income, members of the U.S. Armed Forces may be entitled to an adjustment of income to account for moving expenses. To qualify, the individual must be an active-duty member of the U.S. military. The move must also be to facilitate a permanent change of station.
Moving expenses may only cover the transportation of household items and personal effects and reasonable travel and lodging costs. Unreimbursed moving expenses are deducted using IRS Form 3903.
Student Loan Interest
Eligible taxpayers may be entitled to a student loan interest deduction of up to $2,500 of per year. The student loan must have been taken out for the taxpayer or their spouse/dependents and must be spent solely on education expenses (e.g., tuition, books, school supplies, room and board, etc.) to qualify.
Uses of the Adjusted Gross Income
The IRS uses the AGI for several purposes, including:
- Calculating taxable income — By adjusting the gross income to account for qualified deductions, the IRS arrives at the final income amount on which to base an individual’s tax liability. Twenty-nine U.S. states also use AGI as the starting point for calculating state income tax liability.
- Determining tax bracket — An individual’s taxable income (which needs the AGI) determines their tax bracket.
- Qualifying credits and exemptions — A taxpayer’s AGI plays a vital role in determining what tax credits and exemptions they may be entitled to claim on their tax return. Generally, a taxpayer with a lower AGI will likely be eligible for more tax credits and qualified deductions than someone with a higher AGI.
- Fraud prevention — The IRS requires taxpayers filing their federal tax returns electronically to use the previous year’s AGI to digitally sign and verify their identity.
- Calculating modified adjusted gross income (MAGI) — MAGI is calculated by taking the AGI and adding back excluded income. It is used to determine eligibility for some tax benefits, including whether the taxpayer can contribute to a Roth IRA in a given year.
Calculating Adjusted Gross Income
Calculating the AGI depends on how the tax return is prepared. Individuals using software or an online AGI calculator simply need to input the values, and it will calculate the AGI.
If doing it manually, calculating the AGI begins with adding up all reported income for the year. Next, add any taxable income from other sources—Social Security payments, unemployment compensation, pensions, profit on the sale of a property—to the income tally.
The next step is to subtract all the allowable deductions from the income. The resulting figure is the AGI, which should be slightly lower than or equal to the reported gross income, depending on the taxpayer’s eligibility for adjustment of income deductions. If the AGI ends up higher than the gross income, there’s been an error in calculation.
- Adjusted gross income (AGI) is the resulting figure after eligible adjustments or deductions have been subtracted from an individual’s gross income.
- The IRS uses the AGI for several purposes, such as to determine a taxpayer’s income tax liability for a given year, determine tax brackets, calculate the modified adjusted gross income, and verify taxpayer identity, tax credits, and exemptions.
- When calculating AGI, there are two types of deductions—above-the-line and below-the-line deductions.
- Of these, the former is more important, as these deductions influence the final figure of the AGI, thus the individual’s taxable income.
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